Prepaid Debit Cards: The Lesser of Two Evils?

“I’d take the $3.95 any day over the $35 overdrafting or for some other fees.”

This statement, from a focus group participant, neatly sums up America’s evolving attitude prepaid debit cards. We don’t like the fees, but we like banks even less — and trust providers of prepaid cards more than we trust mainstream banks, according to the Pew Health Group, which conducted the focus groups. And more of us than ever feel that way. Nearly one in five Gen Y and “underbanked” consumers use prepaid debit cards, according to a new study by Javelin Strategy & Research, which finds that the overall percentage of consumers who use them climbed from 11% in 2010 to 13% last year. Research done by Mercator Advisory Group says that in 2009, $28.6 billion was loaded onto prepaid debit cards, an amount that’s expected to skyrocket to $201.9 billion by next year.

There are two big reasons driving the growth: The recession forced banks to write down huge amounts of defaulted credit card debt, to which they responded by tightening lending standards. People who probably could have gotten a credit card five or six years ago might not have that option today.

At the same time, legislation passed in the wake of the financial crisis curtailed the fees banks can charge customers, which made many consumers with low balances unprofitable. Banks have been turning up the heat on these users by increasing fees or adding new ones, more or less hoping they’ll throw up their hands and walk away.

It’s working. Javelin’s research found that fewer people have checking or savings accounts, conventional debit cards or credit cards today than a year ago. At least some of these consumers are switching to prepaid debit cards.

It seems that consumers are beginning to accept the concept that they have to pay for banking services, but the big banks haven’t been the beneficiaries; they still catch flak from customers after adding a new fee or hiking an existing charge. But prepaid users — perhaps because they tend to skew younger and include more people who don’t have traditional banking relationships — have lower expectations for perks like free checking. They take it in stride that they’ll have to pay some of their own money in order to access and manage those funds.

On the other hand, Javelin’s report points out, “The competitive market for prepaid products has led to a variety of innovative card features that correspond to — and sometimes surpass — the features of a traditional checking account.” Prepaid cards weren’t covered by recent legislation that limits the interchange fee — the money merchants pay banks that issue conventional debit cards when they’re swiped at a cash register. As a result, prepaid card companies can tack on bells and whistles like budget-planning tools, linked savings accounts and even rewards programs.

The biggest complaint people have about prepaid cards are the fees. And with good reason: Watchdog group Consumer Action reviewed 28 of the most widely used prepaid debit cards on the market and found a plethora of charges ranging from purchase decline fees to inactivity fees to “load fees” that a user has to pay just to add money. The study highlights ways users can avoid some of the fees, such as reloading cash via direct deposit or transferring from a bank account. But the Javelin research finds that nearly half of prepaid card users reload their cards at a merchant, which usually costs around $4 or $5 a pop.

Pew focus group participants also say they’re essentially paying for enforced self-control. “I know that whatever is on it is the only thing that I can spend. … I know I’m only allowed to use what is on that card,” as one woman put it. Of course, bank accounts and conventional debit cards used to be like that. Yes, it was possible to bounce a check, but small everyday purchases didn’t have the power to zap you with a $35 overdraft fee — potentially repeatedly.

Prepaid debit users think it’s cheaper to use a prepaid card than to have a checking account at a bank, but Consumer Action’s average use estimates found that they could be paying up to $27 a month in fees. It’s a little sad that so many people are willing to part with that much money to be prevented from spending money they don’t have in the first place, but it’s even worse that mainstream banking has gotten to the point where $27 looks like a good deal.